Why 2014 Might Be Lose-Lose for Refinancing

Still upset that you missed the chance to refinance a mortgage when rates were at their lowest point this past spring? Rates may be higher now, but don't exclude the possibility of refinancing. By this time next year, you may be looking back at this as one of the "good old days" for refinancing.

Rather than kicking yourself for missing out on the best refinance rates, and rather than holding out for a return of those rates, you might be better served by taking a fresh look at refinancing now, before the window of opportunity really slams shut.

Ingredients of Refinancing

To understand why you should have a sense of urgency about refinancing, it's important to consider two things: the ingredients of refinancing, and the outcome of the recent budget negotiations between Democrats and Republicans.

There are four major ingredients to refinancing: refinance rates, home equity, creditworthiness of the borrower, and the willingness of banks to make loans.

While recent years have seen mortgage rates fall to record lows, the other three factors have conspired to some degree to prevent many home owners from refinancing. First, home prices fell off steeply, at one point retreating to 2002 levels. This destroyed equity for many homeowners, and in most cases, precluded them from refinancing until they could build equity back up. Meanwhile, given the difficult employment market since the Great Recession, many home owners saw their credit rating take a hit, meaning they could no longer qualify for a home loan. Finally, banks that were burned during the mortgage crisis were much more reluctant to lend, and tightened underwriting standards accordingly.

Over the past year-and-a-half though, home prices have improved dramatically. They are not yet back up to peak levels, but between their partial recovery and the paying down of principal, many home owners should be seeing positive equity emerging once again. Refinance rates, meanwhile, remain very reasonable - as of the end of October, figures from mortgage finance company Freddie Mac showed 30-year mortgage rates less than 1 percent above their all-time low, and lower than the annual average for 39 of the last 40 years.

Thus, 2014 approaches with two of the four ingredients for refinancing - home prices and mortgage rates - working in favor of home owners. However, this brings us to the situation in Washington, which does not bode well for 2014.

Budget and Debt Ceiling Debate May Disrupt 2014

The outcome of the recent budget and debt ceiling debates was not a solution, but a postponement of action until early next year. The outcome of the next confrontation could well set the tone for the economy in 2014. Imagine two types of outcome: an optimistic scenario where a responsible deal is reached which clears the way for the economy to finally sustain some growth, and a pessimistic scenario where continued wrangling further disrupts the economy and the financial markets.

Oddly enough, there are negative consequences for refinancing in each scenario.

The Optimistic Scenario

Uncertainty about fiscal policy has done a great deal to hold back the economy for over a year now. Under the optimistic scenario, a compromise budget deal would give business executives and consumers a clearer notion of what to plan for, and thus allow growth plans to move forward. The stop-and-start economy that has been in place since the end of the Great Recession would finally be able to sustain some momentum.

The downside for refinancing is that this would probably spell an end to the era of super-low mortgage rates. A stronger economy would remove the need for the Federal Reserve to intervene in the bond market to drive rates down, and it would create stronger demand for capital which would be likely to lead to higher rates. A strong enough economy could even revive inflation, which would add another boost to interest rates.

The Pessimistic Scenario

Under the pessimistic scenario, higher refinance rates might not be the problem. However, the other three ingredients of refinancing would be.

If an ugly budget debate keeps consumers in doubt, it could choke off the housing recovery and thus send home equity levels moving back in the wrong direction. Meanwhile, a weakening economy would raise credit concerns among consumers, and make lenders even more reluctant to make loans.

A case could even be made that this pessimistic scenario would lead to higher interest rates, if the credibility of the US as a borrower suffers because the debt ceiling debate threatens its ability to meet its financial obligations.

Thus, while conditions might get a little tougher for refinancing under the optimistic scenario due to rising interest rates, they could be even worse under the pessimistic scenario, as three or even four of the ingredients of refinancing turn against home owners.

How is it possible for such a lose-lose condition to exist for refinancing? It's important to remember that current refinance rates are still among the lowest in history. When things are about as good as they have ever been, any change is likely to be for the worse. Therefore, home owners would do well to look at refinancing before conditions change.